The Modern Portfolio Theory (Advanced Corporate Finance)

Résumé du cours

The Modern Portfolio Theory occupies an important position in the investment management approaches. The theory is distinctive as its application enables investors to minimize the risk involved in investing in different classes of investment by diversifying it with the help of a portfolio. The portfolio is assumed to be a combination of various assets or various types of asset classes so as to take advantage of negative association among the returns of these investments. The Modern Portfolio Theory or MPT is applied on the basis of diversification, risk analysis and risk measurement with the help of beta and CAPM. It also assists an investor to determine an efficient portfolio of assets with the help of efficient frontier line method. This paper provides a study into the fundamentals of Modern Portfolio Theory propounded by Harry Markowitz. It examines and elaborates the important elements of this theory and evaluates its application such as diversification, risk and return analysis, risk measurement, beta and CAPM etc. The paper also is an attempt to analyze the techniques of stock valuation versus technical and fundamental analysis

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Sommaire du cours

Introduction

Modern Portfolio Theory

Markowitz's Modern Portfolio Theory

Stock Valuation

Technical /Fundamental Analysis

Conclusion

Extraits du cours

[...] Mathematically, the return on an investment is measured with the help of Mean of the variable expected by the investors, whereas the risk or variability is measured by calculating Standard Deviation from the Mean. The higher the Standard Deviation from the Mean, the greater will be risk associated with an investment. Risk can be measured with the help of probability distribution such as Expected value and Normal Distribution. Expected value refers to the sum of all possible values multiplied by their respective probabilities. It is a weighted average of project expected values. Variance refers to the difference between the possible values and the expected values. [...]

[...] The risk involved in any portfolio can be evaluated with the help of total risk, covariance and the two-asset portfolio. The formula utilized to assess the risk involved in a portfolio of two investments is: ?p = a2 ?2A + a)2 ?2B +2a(1 COV RB) Where a is the proportion of the total investment to asset is the proportion of total investments to asset ?2A is the variance of return on asset ?2B is the variance of return on asset B and COV RB) is the covariance of the returns on A and B. [...]

[...] The assets that are selected for investment should be negatively correlated so as to minimize the chances of movements in all the assets in the same direction. The risk factor involved in a single class of asset can be reduced by investing in a number of assets. For example, investment in stocks can be diversified with help of investment in other assets such as derivatives, commodities, bonds and real estate. It is, however, important that the assets in a portfolio should be having negative correlation with each other i.e. [...]

[...] The extent of diversification depends upon the number of assets that are included in the portfolio along with the risk associated with it. It is however advisable not to invest in a great number of stocks so as to be able to keep track of all of them accurately Risk and Return Risk and return relationship is very important in the Modern Portfolio theory. The theory puts forward that rational investors are always looking for investments that provide maximum return with minimum risk. [...]

[...] Such risk can be diversified as the number of stocks is increased in a portfolio as we can see in figure 1. The movements in investment return because of unsystematic risk do not represent any relationship with movements in market return. Because of the fact that this return is diversifiable, it is not unsafe and as a result there is no high return for investors bearing this risk Risk Free Assets The risk free assets are those that do not naturally involve any significant risk. [...]